Selling wipes more than £2.5 billion off market cap
Record low interest rates, lowly government bond yields and stubbornly sticky inflation all mean the long-term investor must still concentrate on how to steadily accumulate dependable income from portfolio holdings, in the form of dividend payments. Under such circumstances it is no wonder the Royal Mail (RMG) flotation went so well. The indicative market value of £2.5 billion to £3.3 billion implied the firm was capable of offering a 6.7% yield in its first full year on the market, figures miles above the very best returns on cash, quality bonds, inflation and even the overall equity market yield. Investors swooped in huge numbers, the deal was massively oversubscribed and the shares have roared ahead from their 330p offer price all the way up to 498p at the time of writing.
That was all too much for some and they swiftly pocketed their gains in a classic ‘stagging’ exercise reminiscent of the boom times for privatisations under Margaret Thatcher’s Conservative administration in the 1980s. Others were left a bit deflated as demand was so strong, retail investors who put in for less than £10,000 of stock ended up with £750 worth, or 227 shares. A nice 51% return on that is not to be sniffed at but we are not talking life-changing sums here and many investors will be looking for other ways to boost their savings income, whether they are experienced market players or novices attracted for the first time by the Royal Mail deal.
The latest Government privatisation was every bit as successful as we predicted it would be (see Cover, Shares 26 Sep) because the stock offered that enticing dividend yield at a time when investors were clamouring for dependable income in an uncertain world. Once the initial frenzy ends, Royal Mail will need to demonstrate it can grow its dividend, as research shows this is the very type of stock investors should really buy: firms which provide increases in the distribution outperform on a consistent basis. Not only do they generate income but capital gains too as their shares rise over time.
Shares is yet to be convinced Royal Mail’s business model is robust enough for it to do this, so a watching brief may be best, certainly should the shares ever sail past 500p. In the meantime, the good news is there are many companies out there with investment cases which we feel are superior to those of the newly-privatised firm. Better still, they offer decent yields and look very capable of growing their payments too. Four stocks which look capable of generating income for a balanced portfolio are satellite broadcaster British Sky Broadcasting (BSY), social housing services play Mears (MER), tech stock MicroFocus (MCRO) and defence expert Ultra Electronics (ULE). Those who would rather use a professionally managed fund to harvest their dividends could turn to Gervais’ Williams Diverse Income Trust (DIVI).
Compound returns
Academic research shows up to two-thirds of total shareholder return (TSR) comes from the receipt of dividends and their reinvestment. There are two reasons for this:
• Fat dividend payments can be tucked away and reinvested, bolstering long-term portfolio returns. Shares’ research shows it is the reinvestment that really matters. Since its institution in 1962, the FTSE All-Share has advanced at a compound annual rate of 7.1%, albeit with some big swings up and down. In addition, it has paid an average yield of some 3.8%. Had you put £1,000 into the market 51 years ago but banked no dividends it would be worth a tidy £33,057. Had you targeted that 3.8% yield and reinvested it each year in the stocks that paid the dividends, your nest egg would be £198,848.
• Second, capital gains to supplement income can be accrued by spotting a stock where dividends are not just going to keep trickling in, but keep growing at a healthy rate too (see Why Dividend Growth Matters below).
Some firms have the most stupendous dividend payment records. Halma (HLMA) and James Halstead (JHD:AIM) have upped their annual distribution each and every time for more than 30 years. Their shares have responded in kind.
‘The concept of quality income is about finding companies which have the ability to grow their margins, deliver sustainable returns through a cycle, and, crucially, create a rising stream of cashflow so we can be paid dividends,’ explained Nick Mustoe, chief investment officer at Invesco Perpetual, in a webcast in September. ‘I think the key is really to avoid the typical income sectors that you might see in any equity income portfolio, which have high yields but are effectively “bond proxies”. I think those investments can prove over time to be pretty dangerous. They might offer a headline yield in the short term, but the risk is that if they are not growing that yield, the stock becomes de-rated. This is going to become even more important once the US Federal Reserve begins to taper, or reduce, its asset purchase programme. As long-term bond yields rise, I believe that such “bond proxies” are destined to underperform even more.’
For those investors who feel they do not have the time, expertise or inclination to address these issues and pick individual stocks, professional fund managers can do the job for you. A whole range of investment trusts pay out dividend yields of their own, since they are quoted on the stock market and trade on the London Stock Exchange (LSE) like any other share.
Income-seekers can also target Open-ended investment companies (Oeics). According to Trustnet there are 94 Oeics dedicated to generating the best returns through the purchase of dividend-paying, or income, stocks. The tables below show the top ten by performance over the past three years and those with the highest yield respectively.
Do your homework
A big prospective payout on its own is no guarantee of success, for a fund or stock. Four simple checks can be deployed to measure how safe a dividend is and how much scope a company board has to increase it (see 'Make Sure the Dividend is Safe' below). All of the numbers used here can be quickly and easily found in a company’s latest report and accounts or interim and full-year results, available on its website or via the Regulatory News Service (RNS).
All four of our prime dividend growth stocks pass muster here and each of them, as part of a balanced portfolio, should prove capable of delivering both income and capital gains long after the dust has settled on the Royal Mail deal.
Why dividend growth matters
Shares in Royal Mail (RMG) have rocketed to 498p since official trading in the new market entrant began (11 Oct), miles above the 330p figure at which they had been issued. Such was demand that the institutional chunk of the deal was 20-times oversubscribed and the retail portion seven times as the Government sold a 52.2% stake worth £1.7 billion. The over-allotment option could see allocation of a further 7.8% block to take the total proceeds to £2 billion.
Any institutional investor who offered less than 330p, the high point of the pre-deal indicative range, got nothing. Retail investors were scaled back to 227 shares apiece, or an allocation worth around £750. Those private investors who made a grab for more than £10,000 of stock received no shares at all.
As Shares goes to press, that share price of 498p provides a near-instant return of 51%. This will tempt some buyers to ‘stag’ the issue and take profits straight away.
Those with a longer-term horizon will note Royal Mail’s market capitalisation is now £5 billion. That exceeds the value of no fewer than 32 FTSE 100 constituents so the stock could fly straight in to the premier benchmark at the next index reshuffle in December. This could create some index buying by tracker funds and give the shares a further lift.
At 498p, Royal Mail offers a dividend yield of 4%, based on the £200 million distribution the firm’s prospectus states it would have paid, had it been public for the whole of the year to March 2014. That is still a respectable enough sum, given the returns on cash in the bank and it compares favourably with the 3.4% available from the FTSE All-Share at the time of writing. Furthermore, according to consensus only 21 of Royal Mail’s potential FTSE 100 peers offer more than that. As such income investors may well stay loyal and provide some underpinning for the shares once the market settles down.
Further considerations include the Government’s remaining stake, which it will surely look to sell at some stage, so there could be an overhang, although such technical issues rarely have an impact for long. Of greater import will be a rational assessment of Royal Mail’s business fundamentals, which do not look the strongest. The low growth and high risk mean a premium yield is necessary to entice shareholders to take the risk of backing the firm and once the yield dips under 4% the valuation case starts to weaken. That calculation implies a price of 500p and after that, Royal Mail will need to deliver on its progressive dividend policy and grow the payment to keep investors interested. The debate then will switch to whether it is generating enough cash to permit this, given the need to invest in, and automate, the parcels business.
Growth: LOW
The internet and mobile technology mean the letters market is not growing while parcel delivery is a cut-throat business.
Risk: MEDIUM
Industrial strife is a threat and although Royal Mail has a huge letters market share, parcels is fiercely competitive. Price increases are a potential political issue.
Quality: LOW
The balance sheet has been cleaned up but profits growth has largely come from cost cutting, which is not sustainable.
Oil majors face payout pressure
In the first half of 2013 Royal Dutch Shell (RDSB) and BP (BP.) occupied the top two spots in the value league of first-half dividends according to Capita Registrars Q2 2013 Dividend Monitor report, distributing a combined £6.2 billion to shareholders. Despite this lofty status the table below illustrates how the oil and gas sector, as effectively defined by these two behemoths does not have a record of consistent dividend growth over the last five years.
This period does includes BP’s 2010 Gulf of Mexico oil spill, an event which temporarily forced the company to suspend its payout. Even so, we believe there is a risk both BP and Shell could be inconsistent dividend payers in the future and reckon they are unlikely to be sources of reliable payment growth. Investors should therefore be wary of attractive-looking respective prospective yields of 5.7% and 5.8% for 2014. The risks appear greater at BP given the ongoing uncertainty over the scale of its final bill for the disaster off the US coast (see Under the bonnet, Shares 10 Oct).
By contrast Shell has been remarkably consistent because it has not cut its dividend in more than five decades. The last five years are less impressive since the distribution has been left pretty much unchanged.
There are a number of measures investors can use to determine how safe a payment is but the simplest is dividend cover. This ratio tells us how many times the dividend is covered by earnings. As markets are inherently forward looking it makes sense to use prospective figures based on consensus forecasts. As a rule of thumb cover of less than two could be cause for concern. Based on a forecast 2014 dividend per share of 25.6p and 2014 earnings per share of 57.1p, BP’s offers cover of 2.2 times. The same figures for Royal Dutch Shell - 255p and 119p - also imply a ratio of 2.2. It can be argued this looks a little on the skinny side given the cyclical nature of the oil business and the risk of commodity price volatility.
Cash is king
Dividends are not paid out of earnings but out of cash so to really get to the bottom of both company’s capacity to maintain a generous payout it is important to look at how much liquidity each firm is generating. The table shows net operating cashflow for both companies over the last five years.
This number is always likely to be relatively volatile given the impact of commodity prices and not all the cash generated by either company is funnelled back to shareholders. This is where our real concern lies. Both companies are likely to have to up their capital expenditure in order to grow their reserves of oil and gas. The reserves replacement ratio (RRR) measures the extent to which a company replaces the hydrocarbons it produces with new reserves, such as those discovered through exploration. In theory a company could eventually run out of oil and gas if it fails to maintain the ratio at 100% or higher.
On this basis the numbers for BP and Shell suggest they are finding it increasingly hard to find new sources of oil and gas. The one stand-out year for Shell was 2009 but this was comfortably its best year for exploration in a decade and therefore represented the exception rather than the rule. Using this measure both firms had stinkers in 2012, particularly since BP’s headline number included its divested Russian joint venture TNK-BP. Stripping its contribution out leaves you with a RRR of just 6%
In order to factor in the impact of capital expenditure we can look at free cashflow which indicates broadly how much headroom each company has had to maintain the payout. The charts below also show how many times the dividend is covered by free cashflow.
The forecast figures suggest things will be pretty tight for Shell and that BP has ample breathing space in 2013. Capital investment is always likely to be lumpy and there is the short-term option of using debt to pay the dividend. Over the long-term both companies may well need to invest more to maintain their reserves and ultimately production. This could put greater pressure on their respective payouts. It will certainly be worth watching the RRR number for 2013 when it is reported next year.
Know your numbers
Anyone with aspirations to be a patient portfolio builder should know how to calculate a dividend yield, how to benchmark it and, most importantly of all, ensure this precious payment is safe and not at risk of a cut. A passed payout will ruin your income-based strategy and also probably prompt a share price plunge. There is no point at all investing for dividends if any capital losses suffered offset the benefits of these payouts and more. Dividend yield is calculated as follows and always expressed in percentage terms.
Full-year dividend per share payment
÷
Share price
×
100
=
Dividend yield
Although the historic yield can be used, based on the actual cash payments made by the firm in the previous financial year, stock markets are forward-looking mechanisms and as such investors should focus on forecast, or prospective, dividend figures. Some companies may offer a target for their planned pay-out ratio. This is the percentage of earnings the firm intends to distribute to shareholders in the form of dividends and is simply calculated as follows, and is also expressed as a percentage.
Dividend per share
÷
Earnings per share
×
100
=
Pay-out ratio
Make sure the dividend is safe
Once you are confident about calculating a dividend yield and the pay-out ratio, you must ensure these figures are reliable and you will get those cherished distributions. There are few worse investments than a yield stock where the dividend is cut or even passed altogether. First, you lose out on some, or even all, of the precious payment. Second, the share price is likely to take a thumping.
There are four very easy checks you can make to ensure the dividend payments are safe. Following this list should also help you decide whether a firm is also capable of increasing its shareholder distribution on a consistent basis as such rare stocks tend to be the best providers of both capital gains and income over the long term. The first key test is dividend cover.
Prospective earnings per share (EPS)
÷
Prospective dividend per share (DPS)
=
Dividend cover
This is expressed as a ratio. Ideally cover should exceed 2.0 to 2.5 times. Anything below 2.0 needs to be watched and a ratio under 1.0 suggests danger - unless the firm is a Real Estate Investment Trust (Reit), obliged to pay out 90% of its earnings to maintain its tax status, or it enjoys near guaranteed demand like a utility, has fabulous free cashflow and a strong balance sheet.
The second screen is for operating free cashflow (OpFcF). Lots of this can mean a company has scope to reward investors for their support with dividend payments. OpFcF can be calculated as follows and the data can be easily collected from a firm's financial statements or report and accounts:
Net operating profit
- Tax
+ Depreciation and amortisation
- Capital expenditure
- Increase in working capital
=
Operating free cashflow
The third check is analysis of the balance sheet. A badly-stretched balance sheet could also jeopardise a dividend payout, since a heavily-indebted firm will have to pay interest on its liabilities and repay those obligations at some stage. Ultimately a firm could have to reduce or pass its dividend to preserve cash and ensure its banks are paid so they do not pull the rug from under management. One good measure of a firm's balance sheet is its gearing, or net debt/equity ratio. This is calculated as follows and expressed as a percentage:
Short-term borrowings + Long-term borrowings + Pension liabilities - Cash and cash equivalents
÷
Shareholders funds
×
100
=
Gearing ratio
A positive figures shows the firm has net debt, a negative one net cash. Crudely put, the lower the ratio the stronger the balance sheet, though utilities and other firms with relatively predictable cashflows will be able to carry higher debts more comfortably than cyclical firms, whose income swings around in a much less predictable manner.
A quick look at the interest cover ratio will also help assess a firm's financial soundness.
Operating income PLUS Interest income
÷
Interest expense
=
Interest ratio
The higher the ratio, the better and anything below 1.5 times would be a worrying sign.
Our dividend growth picks
British Sky Broadcasting (BSY) 925p
A first-quarter sales growth figure of 7%, helped by a price increase, demonstrates how sticky pay TV giant BSkyB’s (BSY) 11.2 million customers really are. This kind of pricing power means the FTSE 100 firm is a huge cash machine and one capable of increasing dividends year on year. The fiscal 2013 payout of 30p represented the ninth consecutive annual increment and in the past five years a 32% surge in average revenue per user (ARPU) has fired a 50% hike in the distribution.
Sky offered shareholders an 18% dividend increase last year in the wake of management’s 2011 pledge to return more cash following the failed News Corp (NWS:NDQ) bid. The Murdoch-controlled media empire might still return for a second tilt at BSkyB but management is not resting on its laurels and continues to systematically monetise its premium content.
Last week’s first-quarter results (17 Oct) show that the £14 billion cap’s 11.2 million customers now take an average of 2.9 services. The firm has 32.4 million sign-ups to one type of subscription service or another, a figure up 800,000 in the past quarter alone. Some 219,000 of the new sales were generated by Sky Go Extra whereby customers can add an additional two mobile devices for £5 a month to download content via their set-top boxes or directly from the internet. (SK)
The Diverse Income Trust (DIVI) 74p
Market cap: £239.2 million (as at 31 Aug)
Yield: 2.8% (historic)
Target yield: 4.0%
Investors looking to boost the income-generating portion of their portfolios might look to The Diverse Income Trust (DIVI), a closed-ended fund providing an attractive level of dividends with prospects for dividend growth. Star manager Gervais Williams and colleague Martin Turner have a 'multi-cap' approach which enables them to select the most attractive income stocks from right across the market cap spectrum, although there is a long-term bias towards small and mid-caps. As its name implies, risk is mitigated through a broad-based portfolio of between 80 and 120 names, most of which will not represent more than 1.5% of the fund's value at the time of acquisition. About one-third of the portfolio is invested in Aim-quoted income stocks. The latest available list of the top 20 holdings includes the likes of convenience food producer Greencore (GNC), semiconductors designer CML Microsystems (CML) and recent Aim float and Bargain Booze-owner Conviviality Retail (CVR:AIM). Investors also get exposure to the likes of blue-collar recruiter Staffline (STAF:AIM), plus-size retailer N Brown (BWNG) and meat packing specialist Hilton Food (HFG). (JC)
Mears (MER) 412.75p
Over the past ten years, Mears (MER) has grown its dividend at a 23% compound annual rate, according to calculations by equity strategy boutique Mirabaud. Although the support services group may offer a fairly-low 2.1% prospective yield, it is the mix of sustained dividend growth and capital appreciation that makes this stock far more attractive than first meets the eye.
The £406 million cap has two core revenue streams. It is the market leader in social housing repair and maintenance. It also provides care services, mainly in a person's home as this fits with the government's desire to shift care out of hospitals and into the community.
Two acquisitions in the past year provide firepower to strengthen both revenue streams. Mears bought troubled rival Morrison last November for £24 million. Liberum Capital says there is hidden value in the business and says it could be worth over 30% of Mears' market cap in five years' time.
Six months ago Mears swooped for Scottish homecare provider ILS, a deal which took it higher up the acuity care market and thus into higher-margin business. Its work involves trained nurses, an area for which Mears previously lacked a licence to provide such services. It can now bid for more work around the country, unlocking important growth potential.
Micro Focus (MCRO) 794p
A return to topline growth after years fighting declining revenues shows how IT refresh supplier Micro Focus (MCRO) is more than capable of maintaining its strong momentum. While analysts believe the Newbury-based COBOL specialist will produce flat sales again in the year to end April 2014, with consensus of £265 million compared to £267 million in 2013, revenues are expected to hit over £270 million in 2015, according to numbers crunched by analysts at Panmure Gordon.
This adds an extra dimension to the investment case, which is largely based upon substantial cash returns. Micro Focus has returned £226 million of its dependable cashflow to shareholders since March 2011 through special dividends and regular payouts, while an extra £75 million has been ploughed into share buybacks.
According to Numis’ calculations, a shareholder with 100 shares worth £314 in March 2011 now has 80 shares worth £600 and £123 in cash, assuming no dividend re-investment. That compelling story is set to run, with Micro Focus due to hand over another £90 million, or 60p per share, in November. Further similar special payouts are expected over the coming 12 to 18 months, on top of the predicted $0.44 (27.4p) ordinary dividend to April 2015. The basic payment implies a 3.5% yield and the two added together a juicy 11%, all well supported by an estimated free cashflow (FCF) yield of around 8% this year and next. (SFr)
Ultra Electronics (ULE) £19.07
Aerospace and defence firm Ultra Electronics (ULE) has a track record of increasing the dividend which goes back more than a decade. This more than compensates for the apparently modest yield and the scope for more material contract wins from the company suggests the payout could rise faster than expected, especially as it is well covered by earnings.
The group has around 29 businesses and by combining the efforts of these separate concerns Ultra believes it can secure awards in the £100 million to £300 million bracket and take the next step in its development. The full scale of the opportunity is put at £1.9 billion over the next five years. In the first half the defence sector accounted for 55% of sales. This is a risk given the pressure on defence spending in the West but the firm’s focus on technological niches and diversified model should give it an edge.
Sums from broker Liberum Capital put Ultra’s enterprise value at just more than £1.5 billion or around 9.6 times projected 2014 earnings before interest and tax (EBIT) of £131.9 million. It notes that if this rating was in line with the long-term average and the US peer group then the shares would trade at £20.50. (TS)
